One man's 'Fiscal Adjustment' Is another man's default

As chairman of the Federal Reserve Board, Ben Bernanke is constrained by his ability to speak the truth plainly. People around the world hang on his every word for clues to the Fed's future actions. His comments can move markets. Therefore, he really can't run around with his hair on fire saying what he really thinks or how strongly he thinks it.

But his hair, if not on fire, was spitting sparks last week when he addressed the annual meeting of the Rhode Island Public Expenditure Council. His warning about the perilous fiscal road the United States is barreling down should send chills of fear down the back of every United States citizen.

“History makes clear that countries that continually spend beyond their means suffer slower growth in incomes and living standards and are prone to greater economic and financial instability,” Bernanke said in the opening paragraph of his speech. He continued:

If current policy settings are maintained, and under reasonable assumptions about economic growth, the federal budget will be on an unsustainable path in coming years, with the ratio of federal debt held by the public to national income rising at an existing pace.

Moreover, as the national debt grows, so will the associated interest payments, which in turn will lead to further increases in projected deficits. Expectations of large and increasing deficits in the future could inhibit current household and business spending — for example, by reducing confidence in the longer-term prospects for the economy or by increasing uncertainty about future tax burdens and government spending — and thus restrain the recovery. …

One way or the other, fiscal adjustments sufficient to stabilize the federal government will certainly occur at some point. The only real question is whether these adjustments will take place through a careful and deliberative process that weighs priorities and gives people plenty of time to adjust to changes in government programs or tax policies, or whether the needed fiscal adjustments will be a rapid and painful response to a looming or actual fiscal crisis.

That's pretty straightforward, though abstract. Permit me to fill in some of the blanks and state the case a bit more forthrightly.

If current policies are maintained, the federal debt/GDP ratio will reach 110% in 2015, according to the International Monetary Fund. That's just a hair shy of where Greece's debt/GDP ratio was in 2009 (114.7%) when it stood on the brink of defaulting on its sovereign debt. Admittedly, the U.S. has one big advantage that Greece doesn't when it comes to evading accountability: It has a Federal Reserve Bank that can create all the money it wants and can step in if and when investors stop buying U.S. debt. But conjuring money from the ether and creating hyper-inflation is only default by another name, and the bond vigilantes aren't likely to regard it any more kindly than an outright default.

U.S. finances are hurtling toward a crack-up at an accelerating rate. Based upon an analysis of data covering 101 countries between 1980 and 2008, a recent World Bank research paper contended that one percentage point increase in the ratio of debt to GDP above of 77%, slows the annual rate of economic growth by 0.174%, or nearly one-fifth of a percentage point. The U.S. has shot past the tipping point already, suggesting that economic growth will become increasingly feeble over time as the national debt continues to compound.

As the national debt climbs, so do interest payments on the national debt. Right now, the interest burden is roughly $200 billion a year. The Obama administration expects that to increase to $900 billion a year, even if all of its sunny economic assumptions — such as an interest rate on 10-year Treasury debt that never exceeds 5.3% during the next decade — miraculously come true. But if bond investors spook at the prospect of unpayable government debt, the risk premium they demand from profligate governments like the U.S. could spike interest rates much higher. Moreover, the “global capital glut” that Bernanke has opined upon in previous speeches could turn into a “global capital shortage” as the wave of retirees in aging societies from Japan and Italy to the U.S. start drawing down their savings accounts and depress national savings rates.

A perfect storm of higher interest rates, slower economic growth and a shift in bond investor psychology could bring the U.S. to its knees within just a few years. When I was writing my book “Boomergeddon” earlier this year, I wondered if I was pushing my argument too far by suggesting that the federal government might default on its debt by 2025. Now I wonder if I was too timid. When Bernanke warned opaquely that “fiscal adjustments sufficient to stabilize the federal government” were inevitable, he did not use the “d” word — default. But when he described one possible outcome of such an adjustment as “a rapid and painful response to a looming or actual fiscal crisis,” there can be little doubt as to his meaning.